Some thoughts on stimulus with the Minnesota budget debate

Economics often focuses on "net" effects. A good example is government spending. The federal government has its set of books. So do state and local governments. But when trying to understand the impact of something like the federal government's fiscal stimulus it pays to break down traditional categories.

Take the Minnesota budget battle as a launching point. In the latest installment, Minnesota Public Radio's Tim Post and Tom Scheck report that DFL-lawmakers are trying out a phased approach to dealing with the deficit. The Wall Street Journal took a look at Minnesota's budget problems earlier today with their story, Pawlenty Is Less Popular in Minnesota. (Uunfortunately you need a subscription to read the article.)

The conflict between the governor, who isn't running for re-election, and the state legislature mirrors fights under way in many state capitols. With many states facing historic deficits, lawmakers are divided about whether to just cut spending or rely on a combination of spending cuts and tax increases.

Most states are deep in the red. California may be in the worst shape, but a recent study by the Pew Center on the States convincingly argues that 9 other states have been especially hard hit during the recession: Arizona, Nevada, Oregon, Florida, Illinois, Michigan, Wisconsin, New Jersey, and Rhode Island.

State constitutions mandate balanced budgets. And when the economy is in recession states are a drag on economic growth whether they rely on budget cuts, tax hikes, or a combination of the two fiscal levers. The federal government, however, can operate at a deficit. But state and local cutbacks are a major reason why the federal government's fiscal stimulus hasn't had a bigger impact. In their paper On the Ease of Overstating the Fiscal Stimulus in the US, 2008-9, Joshua Aizenman, economist at University of California, Santa Cruz and Gurnain Kaur Pasricha of the Bank of Canada show that sum of the federal (positive) and states (negative) fiscal expenditures is close to zero for the year they studied.

To summarize, our results indicate that, so far, the federal fiscal expenditure stimulus has mostly compensated for the negative state and local stimulus associated with the collapsing tax revenue and the limited borrowing capacity of the states. While this is a significant accomplishment, the net effect is that the consolidated fiscal expenditure stimulus is small, at a time when the private sector's deleveraging has reduced private consumption. Thus, the fiscal expenditure stimulus did not manage to provide a viable cushion for the negative stimulus associated with private sector's declining demand.

That's a striking summary. In other words, the Great Recession could have been much worse. And how to better balance out federal fiscal policy and state fiscal policy remains a challenge that should be addressed before the next downturn arrives.

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